Title[ Annex
Section[ Annex 4
Treatment of counterparty credit risk and cross-product netting
1. This rule identifies permissible methods for estimating the Exposure at Default
(EAD) or the exposure amount for instruments with counterparty credit risk (CCR) under this Framework.182 Banks may seek supervisory approval to make use of an internal modelling method meeting the requirements and specifications identified herein. As alternatives banks may also use the standardised method or the current exposure method.
I. Definitions and general terminology
2. This section defines terms that will be used throughout this text.
A. General terms
w Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.
B. Transaction types
w Long Settlement Transactions are transactions where a counterparty undertakes to deliver a security, a commodity, or a foreign exchange amount against cash, other financial instruments, or commodities, or vice versa, at a settlement or delivery date that is contractually specified as more than the lower of the market standard for this particular instrument and five business days after the date on which the bank enters into the transaction.
w Securities Financing Transactions (SFTs) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements.
w Margin Lending Transactions are transactions in which a bank extends credit in connection with the purchase, sale, carrying or trading of securities. Margin lending transactions do not include other loans that happen to be secured by securities collateral. Generally, in margin lending transactions, the loan amount is collateralised by securities whose value is greater than the amount of the loan.
C. Netting sets, hedging sets, and related terms
w Netting Set is a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and for which netting is recognised for regulatory capital purposes under the provisions of the 1988 Accord, as amended, this Framework text on credit risk mitigation techniques, or the Cross- Product Netting Rules set forth in this annex. Each transaction that is not subject to a legally enforceable bilateral netting arrangement that is recognised for regulatory capital purposes should be interpreted as its own netting set for the purpose of these rules.
w Risk Position is a risk number that is assigned to a transaction under the CCR standardised method (set out in this annex) using a regulatory algorithm.
w Hedging Set is a group of risk positions from the transactions within a single netting set for which only their balance is relevant for determining the exposure amount or EAD under the CCR standardised method.
w Margin Agreement is a contractual agreement or provisions to an agreement under which one counterparty must supply collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level.
w Margin Threshold is the largest amount of an exposure that remains outstanding until one party has the right to call for collateral.
w Margin Period of Risk is the time period from the last exchange of collateral covering a netting set of transactions with a defaulting counterpart until that counterpart is closed out and the resulting market risk is re-hedged.
w Effective Maturity under the Internal Model Method for a netting set with maturity greater than one year is the ratio of the sum of expected exposure over the life of the transactions in a netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk- free rate. This effective maturity may be adjusted to reflect rollover risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year. The formula is given in paragraph 38.
w Cross-Product Netting refers to the inclusion of transactions of different product categories within the same netting set pursuant to the Cross-Product Netting Rules set out in this annex.
w Current Market Value (CMV) refers to the net market value of the portfolio of transactions within the netting set with the counterparty. Both positive and negative market values are used in computing CMV.
D. Distributions
w Distribution of Market Values is the forecast of the probability distribution of net market values of transactions within a netting set for some future date (the forecasting horizon) given the realised market value of those transactions up to the present time.
w Distribution of Exposures is the forecast of the probability distribution of market values that is generated by setting forecast instances of negative net market valuesequal to zero (this takes account of the fact that, when the bank owes the counterparty money, the bank does not have an exposure to the counterparty).
w Risk-Neutral Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using market implied values such as implied volatilities.
w Actual Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using historic or realised values such as volatilities calculated using past price or rate changes.
E. Exposure measures and adjustments
w Current Exposure is the larger of zero, or the market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. Current exposure is often also called Replacement Cost.
w Peak Exposure is a high percentile (typically 95% or 99%) of the distribution of exposures at any particular future date before the maturity date of the longest transaction in the netting set. A peak exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set.
w Expected Exposure is the mean (average) of the distribution of exposures at any particular future date before the longest-maturity transaction in the netting set matures. An expected exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set.
w Effective Expected Exposure at a specific date is the maximum expected exposure that occurs at that date or any prior date. Alternatively, it may be defined for a specific date as the greater of the expected exposure at that date, or the effective exposure at the previous date. In effect, the Effective Expected Exposure is the Expected Exposure that is constrained to be non-decreasing over time.
w Expected Positive Exposure (EPE) is the weighted average over time of expected exposures where the weights are the proportion that an individual expected exposure represents of the entire time interval. When calculating the minimum capital requirement, the average is taken over the first year or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set.
w Effective Expected Positive Exposure (Effective EPE) is the weighted average over time of effective expected exposure over the first year, or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set where the weights are the proportion that an individual expected exposure represents of the entire time interval.
w Credit Valuation Adjustment is an adjustment to the mid-market valuation of the portfolio of trades with a counterparty. This adjustment reflects the market value of the credit risk due to any failure to perform on contractual agreements with a counterparty. This adjustment may reflect the market value of the credit risk of the counterparty or the market value of the credit risk of both the bank and the counterparty.
w One-Sided Credit Valuation Adjustment is a credit valuation adjustment that reflects the market value of the credit risk of the counterparty to the firm, but does not reflect the market value of the credit risk of the bank to the counterparty.
F. CCR-related risks
w Rollover Risk is the amount by which expected positive exposure is understated when future transactions with a counterpart are expected to be conducted on an ongoing basis, but the additional exposure generated by those future transactions is not included in calculation of expected positive exposure.
w General Wrong-Way Risk arises when the probability of default of counterparties is positively correlated with general market risk factors.
w Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated with the probability of default of the counterparty due to the nature of the transactions with the counterparty.
II. Scope of application
3. The methods for computing the exposure amount under the standardised approach for credit risk or EAD under the internal ratings-based (IRB) approach to credit risk described in this annex are applicable to SFTs and OTC derivatives.
4. Such instruments generally exhibit the following abstract characteristics:
w The transactions generate a current exposure or market value.
w The transactions have an associated random future market value based on market variables.
w The transactions generate an exchange of payments or an exchange of a financial instrument (including commodities) against payment.
w The transactions are undertaken with an identified counterparty against which a unique probability of default can be determined 183.
5. Other common characteristics of the transactions to be covered may include the following:
w Collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions.
w Short-term financing may be a primary objective in that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing. The two sides of the transactions are not the result of separate decisions but form an indivisible whole to accomplish a defined objective.
w Netting may be used to mitigate the risk.
w Positions are frequently valued (most commonly on a daily basis), according to market variables.
w Remargining may be employed.
6. An exposure value of zero for counterparty credit risk can be attributed to derivative contracts or SFTs that are outstanding with a central counterparty (e.g. a clearing house). This does not apply to counterparty credit risk exposures from derivative transactions and SFTs that have been rejected by the central counterparty. Furthermore, an exposure value of zero can be attributed to banks’ credit risk exposures to central counterparties that result from the derivative transactions, SFTs or spot transactions that the bank has outstanding with the central counterparty. This exemption extends in particular to credit exposures from clearing deposits and from collateral posted with the central counterparty. A central counterparty is an entity that interposes itself between counterparties to contracts traded within one or more financial markets, becoming the legal counterparty such that it is the buyer to every seller and the seller to every buyer. In order to qualify for the above exemptions, the central counterparty CCR exposures with all participants in its arrangements must be fully collateralized on a daily basis, thereby providing protection for the central counterparty’s CCR exposures. Assets held by a central counterparty as a custodian on the bank’s behalf would not be subject to a capital requirement for counterparty credit risk exposure.
7. Under all of the three methods identified in this annex, when a bank purchases credit derivative protection against a banking book exposure, or against a counterparty credit risk exposure, it will determine its capital requirement for the hedged exposure subject to the criteria and general rules for the recognition of credit derivatives, i.e. substitution or double default rules as appropriate. Where these rules apply, the exposure amount or EAD for counterparty credit risk from such instruments is zero.
8. The exposure amount or EAD for counterparty credit risk is zero for sold credit default swaps in the banking book where they are treated in the framework as a guarantee provided by the bank and subject to a credit risk charge for the full notional amount.
9. Under all three methods identified in this annex, the exposure amount or EAD for a given counterparty is equal to the sum of the exposure amounts or EADs calculated for each netting set with that counterparty.
III. Cross-product netting rules184
10. Banks that receive approval to estimate their exposures to CCR using the internal model method may include within a netting set SFTs, or both SFTs and OTC derivatives subject to a legally valid form of bilateral netting that satisfies the following legal and operational criteria for a Cross-Product Netting Arrangement (as defined below). The bank must also have satisfied any prior approval or other procedural requirements that its national supervisor determines to implement for purposes of recognising a Cross-Product Netting Arrangement.
Legal Criteria
11. The bank has executed a written, bilateral netting agreement with the counterparty that creates a single legal obligation, covering all included bilateral master agreements and transactions (“Cross-Product Netting Arrangement”), such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative (i) close- out values of any included individual master agreements and (ii) mark-to-market values of any included individual transactions (the “Cross-Product Net Amount”), in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances.
12. The bank has written and reasoned legal opinions that conclude with a high degree of certainty that, in the event of a legal challenge, relevant courts or administrative authorities would find the firm’s exposure under the Cross-Product Netting Arrangement to be the Cross-Product Net Amount under the laws of all relevant jurisdictions. In reaching this conclusion, legal opinions must address the validity and enforceability of the entire Cross- Product Netting Arrangement under its terms and the impact of the Cross-Product Netting Arrangement on the material provisions of any included bilateral master agreement.
w The laws of “all relevant jurisdictions” are: (i) the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located, (ii) the law that governs the individual transactions, and (iii) the law that governs any contract or agreement necessary to effect the netting.
w A legal opinion must be generally recognised as such by the legal community in the firm’s home country or a memorandum of law that addresses all relevant issues in a reasoned manner.
13. The bank has internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by legal opinions that meet the above criteria.
14. The bank undertakes to update legal opinions as necessary to ensure continuing enforceability of the Cross-Product Netting Arrangement in light of possible changes in relevant law.
15. The Cross-Product Netting Arrangement does not include a walkaway clause. A walkaway clause is a provision which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the estate of the defaulter, even if the defaulter is a net creditor.
16. Each included bilateral master agreement and transaction included in the Cross- Product Netting Arrangement satisfies applicable legal requirements for recognition of (i) bilateral netting of derivatives contracts in Annex 3 of the 1988 Accord, as amended in April
1995, or (ii) credit risk mitigation techniques in Part 2, Section II.D of this Framework.
17. The bank maintains all required documentation in its files.
Operational Criteria
18. The supervisory authority is satisfied that the effects of a Cross-Product Netting Arrangement are factored into the firm’s measurement of a counterparty’s aggregate credit risk exposure and that the bank manages its counterparty credit risk on such basis.
19. Credit risk to each counterparty is aggregated to arrive at a single legal exposure across products covered by the Cross-Product Netting Arrangement. This aggregation must be factored into credit limit and economic capital processes.
IV. Approval to adopt an internal modelling method to estimate EAD
20. A bank (meaning the individual legal entity or a group) that wishes to adopt an internal modelling method to measure exposure or EAD for regulatory capital purposes must seek approval from its supervisor. The internal modelling method is available both for banks that adopt the internal ratings-based approach to credit risk and for banks for which the standardised approach to credit risk applies to all of their credit risk exposures. The bank must meet all of the requirements given in Section V of this annex and must apply the method to all of its exposures that are subject to counterparty credit risk, except for long settlement transactions.
21. A bank may also choose to adopt an internal modelling method to measure CCR for regulatory capital purposes for its exposures or EAD to only OTC derivatives, to only SFTs, or to both, subject to the appropriate recognition of netting specified above. The bank must apply the method to all relevant exposures within that category, except for those that are immaterial in size and risk. During the initial implementation of the internal models method, a bank may use the standardised method or the current exposure method for a portion of its business. The bank must submit a plan to its supervisor to bring all material exposures for that category of transactions under the internal model method.
22. For all OTC derivative transactions and for all long settlement transactions for which a bank has not received approval from its supervisor to use the internal models method, the bank must use either the standardised method or the current exposure method. Combined use of the current exposure method and the standardised method is permitted on a permanent basis within a group. Combined use of the current exposure method and the standardised method within a legal entity is only permissible for the cases indicated in paragraph 90 of this annex.
23. Exposures or EAD arising from long settlement transactions can be determined using any of the three methods identified in this document regardless of the methods chosen for treating OTC derivatives and SFTs. In computing capital requirements for long settlement transactions banks that hold permission to use the internal ratings-based approach may opt to apply the risk weights under this Framework’s standardised approach for credit risk on a permanent basis and irrespective to the materiality of such positions.
24. After adoption of the internal model method, the bank must comply with the above requirements on a permanent basis. Only under exceptional circumstances or for immaterial exposures can a bank revert to either the current exposure or standardised methods for all or part of its exposure. The bank must demonstrate that reversion to a less sophisticated method does not lead to an arbitrage of the regulatory capital rules.
V. Internal Model Method: measuring exposure and minimum requirements
A. Exposure amount or EAD under the internal model method
25. CCR exposure or EAD is measured at the level of the netting set as defined in Sections I and III of this annex. A qualifying internal model for measuring counterparty credit exposure must specify the forecasting distribution for changes in the market value of the netting set attributable to changes in market variables, such as interest rates, foreign exchange rates, etc. The model then computes the firm’s CCR exposure for the netting set at each future date given the changes in the market variables. For margined counterparties, the model may also capture future collateral movements. Banks may include eligible financial
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collateral as defined in paragraphs 146 and 703 of this Framework in their forecasting distributions for changes in the market value of the netting set, if the quantitative, qualitative and data requirements for internal model method are met for the collateral.
26. To the extent that a bank recognises collateral in exposure amount or EAD via current exposure, a bank would not be permitted to recognise the benefits in its estimates of LGD. As a result, the bank would be required to use an LGD of an otherwise similar uncollateralised facility. In other words, the bank would be required to use an LGD that does not include collateral that is already included in EAD.
27. Under the Internal Model Method, the bank need not employ a single model. Although the following text describes an internal model as a simulation model, no particular form of model is required. Analytical models are acceptable so long as they are subject to supervisory review, meet all of the requirements set forth in this section and are applied to all material exposures subject to a CCR-related capital charge as noted above, with the exception of long settlement transactions, which are treated separately, and with the exception of those exposures that are immaterial in size and risk.
28. Expected exposure or peak exposure measures should be calculated based on a distribution of exposures that accounts for the possible non-normality of the distribution of exposures, including the existence of leptokurtosis (“fat tails”), where appropriate.
29. When using an internal model, exposure amount or EAD is calculated as the product of alpha times Effective EPE, as specified below:
EAD = ??? Effective EPE (1)
30. Effective EPE (“Expected Positive Exposure”) is computed by estimating expected exposure (EEt) as the average exposure at future date t, where the average is taken across possible future values of relevant market risk factors, such as interest rates, foreign exchange rates, etc. The internal model estimates EE at a series of future dates t1, t2, t3…185
Specifically, “Effective EE” is computed recursively as
Effective EEtk = max(Effective EEtk-1, EEtk) (2)
where the current date is denoted as t0 and Effective EEt0 equals current exposure.
31. In this regard, “Effective EPE” is the average Effective EE during the first year of future exposure. If all contracts in the netting set mature before one year, EPE is the average of expected exposure until all contracts in the netting set mature. Effective EPE is computed as a weighted average of Effective EE:
(3)
Effective EPE ? min(1year ,maturity )? k 1? kt k??? EffectiveEE t
where the weights ?tk = tk – tk-1 allows for the case when future exposure is calculated at dates that are not equally spaced over time.
32. Alpha (?) is set equal to 1.4.
33. Supervisors have the discretion to require a higher alpha based on a firm’s CCR exposures. Factors that may require a higher alpha include the low granularity of counterparties; particularly high exposures to general wrong-way risk; particularly high correlation of market values across counterparties; and other institution-specific characteristics of CCR exposures.
B. Own estimates for alpha
34. Banks may seek approval from their supervisors to compute internal estimates of alpha subject to a floor of 1.2, where alpha equals the ratio of economic capital from a full simulation of counterparty exposure across counterparties (numerator) and economic capital based on EPE (denominator), assuming they meet certain operating requirements. Eligible banks must meet all the operating requirements for internal estimates of EPE and must demonstrate that their internal estimates of alpha capture in the numerator the material sources of stochastic dependency of distributions of market values of transactions or of portfolios of transactions across counterparties (e.g. the correlation of defaults across counterparties and between market risk and default).
35. In the denominator, EPE must be used as if it were a fixed outstanding loan amount.
36. To this end, banks must ensure that the numerator and denominator of alpha are computed in a consistent fashion with respect to the modelling methodology, parameter specifications and portfolio composition. The approach used must be based on the firm’s internal economic capital approach, be well-documented and be subject to independent validation. In addition, banks must review their estimates on at least a quarterly basis, and more frequently when the composition of the portfolio varies over time. Banks must assess the model risk.
37. Where appropriate, volatilities and correlations of market risk factors used in the joint simulation of market and credit risk should be conditioned on the credit risk factor to reflect potential increases in volatility or correlation in an economic downturn. Internal estimates of alpha should take account of the granularity of exposures.
C. Maturity
38. If the original maturity of the longest-dated contract contained in the set is greater than one year, the formula for effective maturity (M) in paragraph 320 of this Framework is replaced with the following:
where dfk is the risk-free discount factor for future time period tk and the remaining symbols are defined above. Similar to the treatment under corporate exposures, M has a cap of five years186.
39. For netting sets in which all contracts have an original maturity of less than one year, the formula for effective maturity (M) in paragraph 320 of this Framework is unchanged and a floor of one year applies, with the exception of short-term exposures as described in paragraphs 321 to 323 of this Framework.
D. Margin agreements
40. If the netting set is subject to a margin agreement and the internal model captures the effects of margining when estimating EE, the model’s EE measure may be used directly in equation (2). Such models are noticeably more complicated than models of EPE for unmargined counterparties. As such, they are subject to a higher degree of supervisory scrutiny before they are approved, as discussed below.
41. A bank that can model EPE without margin agreements but cannot achieve the higher level of modelling sophistication to model EPE with margin agreements can use the following method for margined counterparties. The method is a simple and conservative approximation to Effective EPE and sets Effective EPE for a margined counterparty equal to the lesser of:
w The threshold, if positive, under the margin agreement plus an add-on that reflects the potential increase in exposure over the margin period of risk. The add-on is computed as the expected increase in the netting set’s exposure beginning from current exposure of zero over the margin period of risk.187 A supervisory floor of five business days for netting sets consisting only of repo-style transactions subject to daily remargining and daily mark-to-market, and 10 business days for all other netting sets is imposed on the margin period of risk used for this purpose;
w Effective EPE without a margin agreement.
E. Model validation
42. Because counterparty exposures are driven by movements in market variables, the validation of an EPE model is similar to the validation of a Value-at-Risk (VaR) model that is used to measure market risk. Therefore, in principle, the qualitative standards of the Market Risk Amendment for the use of VaR models should be carried over to EPE models. However, an EPE model has additional elements that require validation:
w Interest rates, foreign exchange rates, equity prices, commodities, and other market risk factors must be forecast over long time horizons for measuring counterparty exposure. The performance of the forecasting model for market risk factors must be validated over a long time horizon. In contrast, VaR for market risk is measured over a short time horizon (typically, one to ten days).
w The pricing models used to calculate counterparty exposure for a given scenario of future shocks to market risk factors must be tested as part of the model validation process. These pricing models may be different from those used to calculate VaR over a short horizon. Pricing models for options must account for the nonlinearity of option value with respect to market risk factors.
w An EPE model must capture transaction-specific information in order to aggregate exposures at the level of the netting set. Banks must verify that transactions are assigned to the appropriate netting set within the model.
w An EPE model must also include transaction-specific information in order to capture the effects of margining. It must take into account both the current amount of margin and margin that would be passed between counterparties in the future. Such a model must account for the nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin period of risk, the minimum threshold of unmargined exposure the bank is willing to accept, and the minimum transfer amount. Such a model must either model the mark-to-market change in the value of collateral posted or apply this Framework’s rules for collateral.
43. Static, historical backtesting on representative counterparty portfolios must be part of the model validation process. At regular intervals as directed by its supervisor, a bank must conduct such backtesting on a number of representative counterparty portfolios (actual or hypothetical). These representative portfolios must be chosen based on their sensitivity to the material risk factors and correlations to which the bank is exposed.
44. Starting at a particular historical date, backtesting of an EPE model would use the internal model to forecast each portfolio’s probability distribution of exposure at various time horizons. Using historical data on movements in market risk factors, backtesting then computes the actual exposures that would have occurred on each portfolio at each time horizon assuming no change in the portfolio’s composition. These realised exposures would then be compared with the model’s forecast distribution at various time horizons. The above must be repeated for several historical dates covering a wide range of market conditions
(e.g. rising rates, falling rates, quiet markets, volatile markets). Significant differences between the realised exposures and the model’s forecast distribution could indicate a problem with the model or the underlying data that the supervisor would require the bank to correct. Under such circumstances, supervisors may require additional capital. Unlike the backtesting requirement for VaR models prescribed under the Market Risk Amendment, no particular statistical test is specified for backtesting of EPE models.
45. Under the internal model method, a measure that is more conservative than Effective EPE (e.g. a measure based on peak rather than average exposure) for every counterparty may be used in place of alpha times Effective EPE in equation (1) with the prior approval of the supervisor. The degree of relative conservatism will be assessed upon initial supervisory approval and subject to periodic validation.
46. Banks using an EPE model or a VaR model (as described in paragraphs 178 to 181
of this Framework) must meet the above validation requirements.
F. Operational requirements for EPE models
47. In order to be eligible to adopt an internal model for estimating EPE arising from CCR for regulatory capital purposes, a bank must meet the following operational requirements. These include meeting the requirements related to the qualifying standards on CCR Management, a use test, stress testing, identification of wrong-way risk, and internal controls.
Qualifying standards on CCR Management
48. The bank must satisfy its supervisor that, in addition to meeting the operational requirements identified in paragraphs 49 to 69 below, it adheres to sound practices for CCR management, including those specified in paragraphs 777 (i) to 777 (xiv) of this Framework.
Use test
49. The distribution of exposures generated by the internal model used to calculate effective EPE must be closely integrated into the day-to-day CCR management process of the bank. For example, the bank could use the peak exposure from the distributions for counterparty credit limits or expected positive exposure for its internal allocation of capital. The internal model’s output must accordingly play an essential role in the credit approval, counterparty credit risk management, internal capital allocations, and corporate governance of banks that seek approval to apply such models for capital adequacy purposes. Models and estimates designed and implemented exclusively to qualify for the internal models method are not acceptable.
50. A bank must have a credible track record in the use of internal models that generate a distribution of exposures to CCR. Thus, the bank must demonstrate that it has been using an internal model to calculate the distributions of exposures upon which the EPE calculation is based that meets broadly the minimum requirements for at least one year prior to supervisory approval.
51. Banks employing the internal model method must have an independent control unit that is responsible for the design and implementation of the firm’s CCR management system, including the initial and on-going validation of the internal model. This unit must control input data integrity and produce and analyse reports on the output of the firm’s risk measurement model, including an evaluation of the relationship between measures of risk exposure and credit and trading limits. This unit must be independent from business credit and trading units; it must be adequately staffed; it must report directly to senior management of the firm. The work of this unit should be closely integrated into the day-to-day credit risk management process of the firm. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the firm’s credit and overall risk profile.
52. The internal model used to generate the distribution of exposures must be part of a counterparty risk management framework that includes the identification, measurement, management, approval and internal reporting of counterparty risk.188 This Framework must include the measurement of usage of credit lines (aggregating counterparty exposures with other credit exposures) and economic capital allocation. In addition to EPE (a measure of future exposure), a bank must measure and manage current exposures. Where appropriate, the bank must measure current exposure gross and net of collateral held. The use test is satisfied if a bank uses other counterparty risk measures, such as peak exposure or potential future exposure (PFE), based on the distribution of exposures generated by the same model to compute EPE.
53. A bank is not required to estimate or report EE daily, but to meet the use test it must have the systems capability to estimate EE daily, if necessary, unless it demonstrates to its supervisor that its exposures to CCR warrant some less frequent calculation. It must choose a time profile of forecasting horizons that adequately reflects the time structure of future cash flows and maturity of the contracts. For example, a bank may compute EE on a daily basis for the first ten days, once a week out to one month, once a month out to eighteen months, once a quarter out to five years and beyond five years in a manner that is consistent with the materiality and composition of the exposure.
54. Exposure must be measured out to the life of all contracts in the netting set (not just to the one year horizon), monitored and controlled. The bank must have procedures in place to identify and control the risks for counterparties where exposure rises beyond the one-year horizon. Moreover, the forecasted increase in exposure must be an input into the firm’s internal economic capital model.
Stress testing
55. A bank must have in place sound stress testing processes for use in the assessment of capital adequacy. These stress measures must be compared against the measure of EPE and considered by the bank as part of its internal capital adequacy assessment process. Stress testing must also involve identifying possible events or future changes in economic conditions that could have unfavourable effects on a firm’s credit exposures and assessment of the firm’s ability to withstand such changes. Examples of scenarios that could be used are; (i) economic or industry downturns, (ii) market-place events, or (iii) decreased liquidity conditions.
56. The bank must stress test its counterparty exposures including jointly stressing market and credit risk factors. Stress tests of counterparty risk must consider concentration risk (to a single counterparty or groups of counterparties), correlation risk across market and credit risk (for example, a counterparty for which a large market move would result in a large exposure, a material deterioration in credit quality, or both), and the risk that liquidating the counterparty’s positions could move the market. Such stress tests must also consider the impact on the firm’s own positions of such market moves and integrate that impact in its assessment of counterparty risk.
Wrong-way risk
57. Banks must be aware of exposures that give rise to a greater degree of general wrong-way risk.
58. A bank is said to be exposed to “specific wrong-way risk” if future exposure to a specific counterparty is expected to be high when the counterparty’s probability of default is also high. For example, a company writing put options on its own stock creates wrong-way exposures for the buyer that is specific to the counterparty. A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk, beginning at the inception of a trade and continuing through the life of the trade.
Integrity of Modelling Process
59. Other operational requirements focus on the internal controls needed to ensure the integrity of model inputs; specifically, the requirements address the transaction data, historical market data, frequency of calculation, and valuation models used in measuring EPE.
60. The internal model must reflect transaction terms and specifications in a timely, complete, and conservative fashion. Such terms include, but are not limited to, contract notional amounts, maturity, reference assets, collateral thresholds, margining arrangements, netting arrangements, etc. The terms and specifications must reside in a secure database that is subject to formal and periodic audit. The process for recognising netting arrangements must require signoff by legal staff to verify the legal enforceability of netting and be input into the database by an independent unit. The transmission of transaction terms and specifications data to the internal model must also be subject to internal audit and formal reconciliation processes must be in place between the internal model and source data systems to verify on an ongoing basis that transaction terms and specifications are being reflected in EPE correctly or at least conservatively.
61. The internal model must employ current market data to compute current exposures. When using historical data to estimate volatility and correlations, at least three years of historical data must be used and must be updated quarterly or more frequently if market conditions warrant. The data should cover a full range of economic conditions, such as a full business cycle. A unit independent from the business unit must validate the price supplied by the business unit. The data must be acquired independently of the lines of business, must be fed into the internal model in a timely and complete fashion, and maintained in a secure database subject to formal and periodic audit. Banks must also have a well-developed data integrity process to scrub the data of erroneous and/or anomalous observations. To the extent that the internal model relies on proxy market data, for example for new products where three years of historical data may not be available, internal policies must identify suitable proxies and the bank must demonstrate empirically that the proxy provides a conservative representation of the underlying risk under adverse market conditions. If the internal model includes the effect of collateral on changes in the market value of the netting set, the bank must have adequate historical data to model the volatility of the collateral
62. The EPE model (and modifications made to it) must be subject to an internal model validation process. The process must be clearly articulated in firms’ policies and procedures. The validation process must specify the kind of testing needed to ensure model integrity and identify conditions under which assumptions are violated and may result in an understatement of EPE. The validation process must include a review of the comprehensiveness of the EPE model, for example such as whether the EPE model covers all products that have a material contribution to counterparty risk exposures.
63. The use of an internal model to estimate EPE, and hence the exposure amount or EAD, of positions subject to a CCR capital charge will be conditional upon the explicit approval of the firm’s supervisory authority. Home and host country supervisory authorities of banks that carry out material trading activities in multiple jurisdictions will work co-operatively to ensure an efficient approval process.
64. In this Framework and in prior documents, the Committee has issued guidance regarding the use of internal models to estimate certain parameters of risk and determine minimum capital charges against those risks. Supervisors will require that banks seeking to make use of internal models to estimate EPE meet similar requirements regarding, for example, the integrity of the risk management system, the skills of staff that will rely on such measures in operational areas and in control functions, the accuracy of models, and the rigour of internal controls over relevant internal processes. As an example, banks seeking to make use of an internal model to estimate EPE must demonstrate that they meet the Committee’s general criteria for banks seeking to make use of internal models to assess market risk exposures, but in the context of assessing counterparty credit risk. 189
65. Pillar 2 of this Framework provides general background and specific guidance to cover counterparty credit risks that may not be fully covered by the Pillar 1 process.
66. No particular form of model is required to qualify to make use of an internal model. Although this text describes an internal model as a simulation model, other forms of models, including analytic models, are acceptable subject to supervisory approval and review. Banks that seek recognition for the use of an internal model that is not based on simulations must demonstrate to their supervisors that the model meets all operational requirements.
67. For a bank that qualifies to net transactions, the bank must have internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by a legally enforceable netting contract that meets the applicable requirements of the 1988
Accord, as amended, this Framework text on credit risk mitigation techniques, or the Cross- Product Netting Rules set forth in this annex.
68. For a bank that makes use of collateral to mitigate its CCR, the bank must have internal procedures to verify that, prior to recognising the effect of collateral in its calculations, the collateral meets the appropriate legal certainty standards as set out in Part
2, Section II.D of this Framework.
VI. Standardised Method
69. Banks that do not have approval to apply the internal models method for the relevant OTC transactions may use the standardised method. The standardised method can be used only for OTC derivatives; SFTs are subject to the treatments set out under the Internal Model Method of this Annex or under the Part 2, Section II.D, of this Framework. The exposure amount (under the standardised approach for credit risk) or EAD is to be calculated separately for each netting set. It is determined as follows:
exposure amount or EAD =
where:
CMV =
current market value of the portfolio of transactions within the netting set with a counterparty gross of collateral, i.e. CMVi is the current market value of transaction i.
CMC =
current market value of the collateral assigned to the netting set, i.e.
, where CMCl is the current market value of collateral l.
i = index designating transaction.
l = index designating collateral.
j = index designating supervisory hedging sets. These hedging sets correspond to risk factors for which risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based.
RPTij = Risk position from transaction i with respect to hedging set j 190.
RPClj = Risk position from collateral l with respect to hedging set j.
CCFj = Supervisory credit conversion factor with respect to the hedging set j 191.
? = Supervisory scaling parameter.
Collateral received from a counterparty has a positive sign; collateral posted to a counterparty has a negative sign.
Collateral that is recognised for the standardised approach is confined to the collateral that is eligible under paragraphs 146 and 703 of this Framework for credit risk mitigation.
70. When an OTC derivative transaction with linear risk profile (e.g. a forward, a future or a swap agreement) stipulates the exchange of a financial instrument (e.g. a bond, an equity, or a commodity) for a payment, the payment part is referred to as the payment leg. Transactions that stipulate the exchange of payment against payment (e.g. an interest rate swap or a foreign exchange forward) consist of two payment legs. The payment legs consist of the contractually agreed gross payments, including the notional amount of the transaction. Banks may disregard the interest rate risk from payment legs with a remaining maturity of less than one year from the following calculations. Banks may treat transactions that consist of two payment legs that are denominated in the same currency (e.g. interest rate swaps) as a single aggregate transaction. The treatment for payment legs applies to the aggregate transaction.
71. Transactions with linear risk profiles that have equity (including equity indices), gold, other precious metals or other commodities as the underlying financial instruments are mapped to a risk position in the respective equity (or equity index) or commodity (including gold and the other precious metals) hedging set. The payment leg of these transactions is mapped to an interest rate risk position within the appropriate interest rate hedging set. If the payment leg is denominated in a foreign currency, the transaction is also mapped to a foreign exchange risk position in the respective currency.
72. Transactions with linear risk profiles that have a debt instrument (e.g. a bond or a loan) as the underlying instrument are mapped to an interest rate risk positions with one risk position for the debt instrument and another risk position for the payment leg. Transactions with linear risk profiles that stipulate the exchange of payment against payment (including foreign exchange forwards) are mapped to an interest rate risk position for each of the payment legs. If the underlying debt instrument is denominated in a foreign currency, the debt instrument is mapped to a foreign exchange risk position in the respective currency. If a payment leg is denominated in a foreign currency, the payment leg is also mapped to a foreign exchange risk position in this currency.192 The exposure amount or EAD assigned to a foreign exchange basis swap transactions is zero.
73. For all but debt instruments, the size of a risk position from a transaction with linear risk profile is the effective notional value (market price multiplied by quantity) of the underlying financial instruments (including commodities) converted to the firm’s domestic currency.
74. For debt instruments and the payment legs of all transactions, the size of the risk position is the effective notional value of the outstanding gross payments (including the notional amount) converted to the firm’s domestic currency, multiplied by the modified duration of the debt instrument or payment leg, respectively.
75. The size of a risk position from a credit default swap is the notional value of the reference debt instrument multiplied by the remaining maturity of the credit default swap.
76. The size of a risk position from an OTC derivative with non-linear risk profile
(including options and swaptions) is equal to the delta equivalent effective notional value of the financial instrument that underlies the transaction, except in the case of an underlying debt instrument.
77. For OTC derivative with non-linear risk profiles (including options and swaptions), for which the underlying is a debt instrument or a payment leg, the size of the risk position is equal to the delta equivalent effective notional value of the financial instrument or payment leg multiplied by the modified duration of the debt instrument or payment leg.
78. Banks may use the following formulas to determine the size and sign of a risk position:
a. for all but debt instruments:
effective notional value, or delta equivalent notional value =
where
pref price of the underlying instrument, expressed in the reference currency
v value of the financial instrument (in the case of an option: option price; in the case of a transaction with a linear risk profile: value of the underlying instrument itself)
p price of the underlying instrument, expressed in the same currency as v
b. for debt instruments and the payment legs of all transactions:
effective notional value multiplied by the modified duration, or
delta equivalent in notional value multiplied by the modified duration
where
v value of the financial instrument (in the case of an option: option price; in the case of a transaction with a linear risk profile: value of the underlying instrument itself or of the payment leg, respectively)
r interest level
If v is denominated in a currency other than the reference currency, the derivative must be converted into the reference currency by multiplication with the relevant exchange rate.
79. The risk positions are to be grouped into hedging sets. For each hedging set, the absolute value amount of the sum of the resulting risk positions is computed. This sum is termed the “net risk position” and is represented as
in the formulas in paragraph 70 of this annex.
80. Interest rate positions arising from debt instruments of low specific risk are to be mapped into one of six hedging sets for each represented currency. A debt instrument is classified as being of low specific risk when it is subject to a 1.6 percent or lower capital charge under the revised rules for specific risk in the standardised approach to market risk
(Section A.1.I of the updated Market Risk Amendment). Interest rate positions arising from the payment legs are to be assigned to the same hedging sets as interest rate risk positions from debt instruments of low specific risk. Interest rate positions arising from money deposits received from the counterparty as collateral are also to be assigned to the same hedging sets as interest rate risk positions from debt instruments of low specific risk. The six hedging sets per currency are defined by a combination of two criteria:
(i) The nature of the referenced interest rate — either a sovereign (government) rate or some other rate.
(ii) The remaining maturity or rate-adjustment frequency — less than one year, between one and five years, or longer than five years.
Table 1
Hedging Sets for Interest Rate Risk Positions Per Currency
Remaining maturity or rate-adjustment frequency
Sovereign-referenced interest rates
Non-sovereign- referenced interest rates
One year or less X X
Over one year to five years X X
Over five years X X
81. For underlying debt instruments (e.g. floating rate notes) or payment legs (e.g. floating rate legs of interest swaps) for which the interest rate is linked to a reference interest rate that represents a general market interest level (e.g. government bond yield, money market rate, swap rate), the rate-adjustment frequency is the length of the time interval up to the next re-adjustment of the reference interest rate. Otherwise, the remaining maturity is the remaining life of the underlying debt instrument, or, in the case of a payment leg, the remaining life of the transaction.
82. There is one hedging set for each issuer of a reference debt instrument that underlies a credit default swap.
83. There is one hedging set for each issuer of a debt instrument of high specific risk, i.e. debt instruments to which a capital charge of more than 1.60 percent applies under the standardised measurement method for interest rate risk following Section A.1.I of the updated Market Risk Amendment. The same applies to money deposits that are posted with a counterparty as collateral when that counterparty does not have debt obligations of low specific risk outstanding. When a payment leg emulates a debt instrument of high specific risk (e.g. in the case of a total return swap with one leg that emulates a bond), there is also one hedging set for each issuer of the reference debt instrument. Banks may assign risk positions that arise from debt instruments of a certain issuer or from reference debt instruments of the same issuer that are emulated by payment legs or that underlie a credit default swap to the same hedging set.
84. Underlying financial instruments other than debt instruments (equities, precious metals, commodities, other instruments), are assigned to the same respective hedging sets only if they are identical or similar instruments. The similarity of instruments is established as follows:
w For equities, similar instruments are those of the same issuer. An equity index is treated as a separate issuer.
w For precious metals, similar instruments are those of the same metal. A precious metal index is treated as a separate precious metal.
w For commodities, similar instruments are those of the same commodity. A
commodity index is treated as a separate commodity.
w For electric power, delivery rights and obligations that refer to the same peak or off- peak load time interval within any 24 hour interval are similar instruments.
85. The credit conversion factor that is applied to a net risk position from a hedging set depends on the supervisory hedging set category as given in paragraphs 86 to 88 of this annex.
86. The credit conversion factors for underlying financial instruments other than debt instruments and for foreign exchange rates are given in Table 2.
Table 2
Exchange
Rates Gold Equity Precious Electric Other
Metals Power Commodities
(except gold) (excluding precious metals)
2.5% 5.0% 7.0% 8.5% 4% 10.0%
87. The credit conversion factor for risk positions from debt instruments are as follows:
w 0.6 percent for risk positions from a debt instrument or reference debt instrument of high specific risk.
w 0.3 percent for risk position from a reference debt instrument that underlies a credit default swap and that is of low specific risk.
w 0.2 percent otherwise.
88. Underlying instruments of OTC derivatives that are not in any of the categories above are assigned to separate individual hedging sets for each category of underlying instrument. A credit conversion factor of 10 percent is applied to the notional equivalent amount.
89. There may be transactions with a non-linear risk profile for which the bank cannot determine the delta with a model that the supervisor has approved for the purposes for determining the minimum capital requirements for market risk (instrument models approved for the purposes of the standardised approach for market risk, or instrument models approved as part of the firm's admission to the internal modelling approach for market risk). In the case of payment legs and transactions with debt instruments as underlying, there may be transactions for which the bank cannot determine the modified duration with such a model. For these transactions, the supervisor will determine the size of the risk positions and the applicable credit conversion factors conservatively. Alternatively, supervisors may require the use of the current exposure method. Netting will not be recognised: in other words, the exposure amount or EAD is to be determined as if there were a netting set that comprises just the individual transaction.
90. The supervisory scaling parameter ? (beta) is set at 1.4.
VII. Current Exposure Method
91. Banks that do not have approval to apply the internal models method may use the current exposure method as identified in paragraphs 186, 187 and 317 of this Framework. The current exposure method is to be applied to OTC derivatives only; SFTs are subject to the treatments set out under the Internal Model Method of this Annex or under the Part 2, Section II.D, of this Framework.
92. The credit conversion factors used to calculate add-ons are as prescribed in the
1988 Accord, as amended in April 1995193, as well as in paragraph 186 of this Framework. These credit conversion factors under the current exposure method remain set as follows in Table 3:
Table 3
Interest Rates FX and
Gold Equities
Precious Metals Except Gold
Other
Commodities
One year or less 0.0% 1.0% 6.0% 7.0% 10.0%
Over one year to
five years 0.5% 5.0% 8.0% 7.0% 12.0%
Over five years 1.5% 7.5% 10.0% 8.0% 15.0%
93. Banks can obtain capital relief for collateral as defined in paragraphs 146 and 703 of this Framework. The methodology for the recognition of eligible collateral follows that of the applicable approach for credit risk.
94. The counterparty credit risk exposure amount or EAD for single name credit derivative transactions in the trading book will be calculated using the potential future exposure add-on factors set out in paragraph 707 of this Framework.
95. To determine capital requirements for hedged banking book exposures, the treatment for credit derivatives in this Framework applies to qualifying credit derivative instruments.
96. Where a credit derivative is an nth-to-default transaction (such as a first-to-default transaction), the treatment specified in paragraph 708 of this Framework applies.
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